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Bridge master Jimmy Cayne skillfully played his hand in leading Bear Stearns on a surprising run. Can he keep the firm’s seat at the table as the game changes?
Then hes not running his investment bank, Bear Stearns Cos. chairman and CEO James Cayne is usually off somewhere playing bridge friendly matches with the likes of Bill Gates and Warren Buffett or high-level amateur competitions held around the country. To Cayne, bridge isnt just a game, its a way of life, a philosophy. As a young man he paid the bills with bridge winnings and dreamed of making a career as a card shark. Today he has no trouble making ends meet he earned $28.4 million last year and is worth more than $1 billion and attributes his success in finance and bridge to the same principle: The best players make the most of the hands theyre dealt. Comparing cards to business, Cayne told a group of interns in July, Bridge requires skill and preparation, not luck.
Thats the mind-set with which Cayne approaches his other great love: running Bear. During 13 years as CEO, he has repeatedly foiled predictions of his firms imminent decline. Skeptics have long dismissed 83-year-old Bear, the smallest of Wall Streets
big, publicly traded securities houses, as prime takeover bait, a déclassé firm too narrowly focused to survive in a business where size and reputation are all-important. Unlike Goldman Sachs Group and Morgan Stanley, Bear cant lay claim to an elite client list. It lacks the diversity, global reach and beefy balance sheets of the universal banks, such as Citigroup, Deutsche Bank and JPMorgan Chase & Co., that are making inroads on traditional Wall Streets turf. And Caynes firm has run into regulatory hot water. In March it agreed to pay $250 million to settle Securities and Exchange Commission charges that its clearing unit helped customers engage in illegal late trading of mutual fund shares This came seven years after Bear paid $35 million and hired an independent compliance consultant to settle SEC allegations that it failed to detect and take action against fraudulent conduct by one of its clearing clients, the notorious (and now defunct) boiler room brokerage A.R. Baron & Co. Bear was one of 12 big brokerage houses that in 2003 and 2004 settled charges by federal and state regulators that it had published misleading stock research in an effort to win corporate underwriting and advisory business.
Despite all this, since succeeding Alan (Ace) Greenberg as chairman in June 2001, Cayne has led Bear on a remarkable run during which time it has outperformed nearly every competitor in earnings growth and stock price appreciation. Last year it posted record profits of $1.46 billion, up a dizzying 136 percent since 2001. Through September 30 of this year, the firm had already surpassed that total, earning $1.49 billion. Over the past five years, Bears share price has increased by 175 percent, to $151, outperforming white-shoe firms like Goldman (112 percent) and Morgan Stanley (52 percent).
Still, by many measures, Bear remains far behind its rivals. At $22 billion, its market capitalization is barely half that of its next-biggest competitor, Lehman Brothers, and it is dwarfed by Goldmans $82 billion and Citigroups $249 billion. Investors, concerned about the firms lack of diversification and its propensity for regulatory run-ins, currently value Bears shares at 11 times projected 2007 earnings lower than all but one of its major competitors (Goldmans multiple is 10.7). Its price-to-book valuation of 1.97 is the lowest of its peer group.
Cayne has defied skeptics by investing excess cash in unglamorous but fast-growing markets like asset-backed securities, collateralized debt obligations and credit derivatives. Bear is the leading underwriter of mortgage-backed securities. It cant outperform Citi, Goldman and Morgan Stanley in the high-profile equity underwriting and corporate merger advisory arenas, and it doesnt try to. Rather, it focuses on serving a small group of corporate clients with whom it has long-standing relationships, such as Verizon Communications and Time Warner, as well as on highly active private equity firms. In a nutshell, the firm has chosen profits over prestige.
Just as important to Caynes success has been preserving the firms longtime focus on cost controls. Greenberg, his mentor and onetime bridge partner, was renowned for his penny-pinching, urging employees to reuse paper clips and rubber bands. During Caynes five years as chairman, annual expenses have grown by just 31 percent, even as revenues have leaped by 51 percent.
Theyre a wealth-creation machine, says Bruce Sherman, CEO of Private Capital Management, a Naples, Floridabased money manager that owns 6.5 percent of Bear and is the firms largest shareholder. Jimmys leadership over the past decade has been central to that.
Bear has also benefited from good luck and fortuitous timing. Its dependence on fixed income last year 44 percent of revenue came from debt sales and trading has long been considered a limitation by critics in the investment community. But lately it has been a key to the firms outperformance, as low interest rates and postbubble caution fueled a bond and loan boom. Bear was an early entrant to the business of prime brokerage, which provides hedge funds with a single point of contact for trade execution, securities lending, recordkeeping and other services. Last year Bear collected 15 percent of the $5.5 billion spent by rapidly proliferating hedge funds on prime brokerage, estimates Sanford C. Bernstein & Co. analyst Charles (Brad) Hintz. That puts Bear third in that lucrative arena, behind Goldman and Morgan Stanley.
Because it had a smaller presence in the equity and M&A advisory businesses that tanked after the 1990s stock bubble burst, Bear flourished while its competitors struggled. In 2003 the firm finished the construction of a $500 million, 47-story, octagonal headquarters two blocks north of Grand Central Terminal on Manhattans east side. Cayne describes the building as his greatest achievement as CEO a tangible expression of Bears success and staying power. Its a square block in the heart of the city, he notes proudly.
Now, however, Caynes winning hand is being challenged: The cycle of low interest rates and investor caution is turning. Rising rates have contributed to a housing slowdown that could hurt Bears booming mortgage business, reducing the supply of new loans to be securitized and dampening the enthusiasm of mortgage bond investors. At the same time, the long-dormant equity and M&A markets, in which Bear trails the competition, are reawakening. Worldwide merger volume this year hit $2.9 trillion through October, breaking the $2.8 trillion record for the same period in 2000. Stock underwriting rose 15 percent during 2006s first nine months over the same period a year earlier. Bear ranks just 12th among U.S. merger advisers on deals announced this year, behind the likes of boutique Evercore Partners and Banc of America Securities; it also registers 12th in U.S. equity underwriting, according to Dealogic.
And Bear is notably weak overseas, especially in the fast-growing Asian and European markets that U.S. firms increasingly see as critical for the future. Globally, Bear ranks 21st in M&A and 17th in equity underwriting. It is alone among its peers in lacking a strategic partner in China, a market that Wall Street has been madly pursuing. (Cayne refuses to comment on reports earlier this year that Bear was in talks to sell a 20 percent stake to China Construction Bank for $4 billion, a deal that would have given the U.S. firm critical access to deal flow in China. Both sides have publicly denied being in negotiations.)
Meanwhile, Bears position in prime brokerage is under attack, as firms like Citi, Bank of America Corp. and Deutsche Bank invest in the business, wooing customers with liberal lending terms and expensive state-of-the-art technology. Rather than sticking with one prime brokerage, hedge funds are increasingly playing the competitors against one another. Although the business is growing, Bear is in danger of losing share to its aggressive rivals. Revenues in the firms global clearing unit, which includes prime brokerage, declined 7 percent between the second and third quarters of this year.
Together, these developments could leave Bear vulnerable to takeover. Some still view the firm as a target for its competitors, especially because the gaps in its business lines would mean less duplication and layoffs during a merger integration.
Its not a company thats in a desperate position, that has to sell, but it could bring added value to potential purchasers without the large overlapping businesses that many larger firms would bring, says analyst Hintz.
A chain-smoker of Montecristo cigars he even puffs them in the firms elevators Cayne came of age in the era before Wall Streets private partnerships went corporate and its leaders began to stick to polished scripts. He still leaves his door open to everyone from senior managing directors to interns. But in a blink he can go from gregarious to gruff, and he is as adept at dressing down those who aggravate him as he is at glad-handing clients. In a 2004 memo to Bear employees, he admonished co-president Warren Spector for expressing his support for Democratic presidential candidate John Kerry during a company conference call. (Cayne supported President George W. Bush.)
Although Cayne loves his job and is a youthful 72 he frequently listens to Generation X singer Natalie Merchant and other popular music in his office he wont be able to do it forever. Hes easily the oldest major-firm CEO on Wall Street. Greenberg was 65 when he surrendered the chief executive job to Cayne and 73 when he stepped down as chairman.
Any successful bridge player needs strong partners, and over the past few years, Cayne has delegated many day-to-day responsibilities to Bears two co-presidents: Spector, 48, who oversees fixed income and asset management, and Alan Schwartz, 55, who runs investment banking, equities and merchant banking (see box). And Cayne hints that there are aspects of the job that wear him down. Being Bears public face, which means dealing with shareholders, regulators and the media, can bring stress. He says he often takes business setbacks personally. There is an awful lot of gratification that comes with this job, he explains. There is also heartache.
BORN TO A MIDDLE-CLASS family in the Chicago suburb of Evanston, Illinois, Cayne had no desire to be a businessman, nor did he want to follow in the footsteps of his father, a patent attorney. He spent most of his early adulthood pursuing a good time. After two years he dropped out of Indianas Purdue University, where he had devoted more time to playing bridge than to studying. In 1954 he enlisted in the Army and was stationed in Japan as a court reporter. When he returned home in 1956, he got a job as a traveling salesman of photocopier equipment in the Midwest. During one long sales trip, he fell asleep behind the wheel of his Ford and hit a utility pole; a judge suspended his drivers license. Soon thereafter Cayne married Maxine Kaplan and went to work for her father, a Chicago scrap-iron and metals broker. The marriage ended in divorce, and in 1964 he headed to New York, determined to become a professional bridge player. To supplement his income, he worked as a salesman at municipal bond house Lebenthal & Co.
I earned enough to get by and enjoy a fun bachelor life, he recalls.
Cayne began working at Bear to impress Patricia Denner, a speech therapist he had met at a bridge tournament. After a few dates Denner gave him an ultimatum: Get a real job or a new girlfriend. He joined the firm as a retail broker in 1969, at age 35, and married Denner in 1971. Not surprisingly, his first client was one of his bridge partners.
Bears culture suited Cayne perfectly. Founded in 1923 by Joseph Bear, Robert Stearns and Harold Mayer, the firm had long been run by scrappy entrepreneurs who cared more about making money than about what people thought of them. For Bears employees, from the seniormost partner to the greenest recruit, pedigree counted for nothing. It was the kind of place where bright, ambitious young men could make fortunes.
When Cayne joined the firm, it was run by Salim (Cy) Lewis, a martini-loving ladies man and legendary trader he invented the now-common strategy of merger arbitrage who had transformed Bear from a tiny brokerage into a high-flying trading house. Lewis died at age 69 of a massive stroke suffered during his 1978 retirement party and was succeeded by Greenberg, an Oklahoma City native who joined Bear as a clerk in 1949 after being rejected by six other firms. Greenberg was among those who interviewed Cayne, and the pair soon became bridge partners. After work they would get together for games at Manhattans Regency Whist Club with retailer Milton Petrie and Laurence Tisch, then CEO of Loews Corp.
Greenbergs protégé got his big break in the early 1970s when a financial crisis gripped New York City. While working the phones for clients who wanted to sell the citys distressed bonds, Cayne realized that other Wall Street firms were unwilling to make a market in them. He quickly recommended to his bosses that Bear step in and bridge the gap. When they rejected the idea, he took it straight to Lewis, who gave him the green light. Cayne found buyers who were willing to take on the bonds at higher prices, and Bear made a killing.
It was a great chapter in the history of the firm, boasts Cayne, because it changed the brand picture of the company.
At about the same time, Bear started its clearing division. This began as an afterthought the firm had extra office space that it let smaller firms use for free, provided they chose Bear as a clearing broker but soon became a potent source of profits. From the late 1970s into the 80s, Greenberg expanded the business. In 1983 he led the firm into the nascent mortgage-backed-securities market, along with such pioneers as Salomon Brothers, and government bond trading.
In 1985, Bear went public, bowing to changes on Wall Street that made offering financing to clients and having a bigger, permanent capital base more important. The partners elected Cayne president under Greenberg, who became chairman and CEO.
Since then Bear has maintained its focus on earnings. During the late 1980s and through the 90s, as securities firms grew rapidly and diversified through mergers and acquisitions, Bear stuck to its strengths mainly, fixed income and clearing. Though the firm pushed into investment banking, Greenberg measured Bears success by its stock price and the return it generated on shareholders equity. The firms stock increased sevenfold in the 15 years following the 1985 IPO, compared with a fivefold gain for the Standard & Poors 500 index.
Since Greenbergs retirement Cayne has picked up where his mentor left off. He has invested, for example, in building Bears mortgage-backed-securities business, which provides about 30 percent of the firms fixed-income revenues. Selling bonds based on baskets of mortgage loans isnt as glamorous as advising on big mergers or taking companies public, but the move paid off when mortgage rates tumbled and originations soared. Last year, in a move to ensure a more consistent supply of loans for securitization, the firm launched its own mortgage lender, Bear Stearns Residential Mortgage Corp., which originates loans in 29 states through the Web site Beardirect.net. Last month Bear plunged further into the business, buying the subprime mortgage unit of ECC Capital Corp. for $26 million. Bear originated 31 percent of the loans it securitized in the third quarter, almost double the ratio from one year earlier. The firm also aims to control its supply of loans for securitization in Europe: Last year it bought London-based subprime mortgage broker Essex & Capital Mortgage Corp. In June, Bear transferred three senior mortgage bankers to London, including 20-year veteran Frederick Khedouri, whom the firm named head of European residential mortgage and consumer loan origination.
Bear has exploited other lucrative capital markets, including credit and equity derivatives and structured-credit products. Last year it was the fourth-most-prolific underwriter of collateralized debt obligations, according to Thomson Financial. It continues to develop innovative products, including the first-ever derivative designed to hedge the risk of defaults on U.S. commercial-mortgage-backed securities.
The firm picks its spots carefully in investment banking, emphasizing those areas where it can maximize profits. Co-president Schwartz says Bear seeks repeat business with a core group of clients instead of chasing hot products and sectors or trying to gain market share for its own sake. One such client is media giant Time Warner, which Bear advised last year on its $17.6 billion purchase with Comcast Corp. of Adelphia Communications Corp.s cable systems. Another is Verizon Communications, which Bear is advising on the estimated $15 billion spin-off of its yellow-pages business.
Bears work with yellow-pages publisher R.H. Donnelley Corp. illustrates the firms approach. The company hired Bear in October 2005 as an adviser on its $4.2 billion acquisition of the directory business of telecommunications provider Qwest Communications International. Bear won that mandate largely because of the impression Schwartz had made on Donnelley CEO David Swanson and CFO Steven Blondy three years earlier, when Bear came through with a financing package for Donnelleys $2.23 billion purchase of Sprints phone-book unit. Other firms, including Morgan Stanley, had tried for the financing mandate but took too long negotiating their internal bureaucracies to secure the commitment.
At the last hour Bear was there with the money and the advice, recalls Blondy, who came to Donnelley in 2002 from a corporate development position at Young & Rubicam, where Schwartz is a director. Morgan Stanley was there with the advice but dropped the ball on the money.
Because Bear is focused on a smaller group of clients, it often can give them higher-level attention than they might receive at bigger, more prestigious shops. The advice I get from Bear Stearns is head and shoulders better than what I get from Morgan Stanley and Goldman Sachs, Blondy says. Its not even close. I have a relationship with the president and am getting his direct involvement instead of the rank and file. Maybe thats not as scalable at some of the other firms.
Says Schwartz, We dont see a very high correlation between league table market share and profitability.
One of Bears most successful tactics in investment banking has been catering to increasingly influential leveraged-buyout firms, which are involved in nearly 20 percent of mergers and acquisitions these days, as well as the debt offerings and IPOs of their portfolio companies. The firm did little business with these clients until 1998, when Cayne recruited Keith Barnish, now co-head of leveraged finance, from Bank of America to develop an in-house lending capability a must for serving the buyout firms.
Bear has made a positive impression on LBO titan Blackstone Group, which in July closed on the biggest buyout fund ever, at $15.6 billion. In 2004, Blackstone expressed interest in buying lodging company Extended Stay America. Lawrence (Lonny) Henry, a senior real estate and lodging banker at Bear, came up with a creative structure: Blackstone should borrow against the real estate holdings of Extended Stay rather than issue the straight corporate debt that backs most leveraged buyouts. Increased investor demand for the asset-backed debt allowed Blackstone to put up just 20 percent of the purchase price in cash, compared with the 30 percent that would have been required if it had issued straight bonds. Bear won both the advisory and the financing mandates for the $3.1 billion deal, which was completed in March 2005.
It was the first time anyone had used mortgage financing to complete a corporate buyout, and it was critical in getting the deal done, says Jonathan Gray, co-head of Blackstones U.S. real estate group. In June, Bear advised Blackstone on its $8.9 billion acquisition, made in partnership with Brookfield Properties Corp., of real estate developers Trizec Properties and Trizec Canada.
Bears below-the-radar approach extends to its own private equity activities. In April the firm raised a $2.7 billion fund, a follow-up to the $1.5 billion pool it assembled in 2000. Schwartz, who runs principal investing, says Bear mostly targets companies worth $1 billion or less so that it doesnt compromise its ability to assist big firms like Blackstone, which typically buy much larger companies. The 2000 fund has investments in more than 20 companies, including Vitamin Shoppe and Sutton Place Group, which operates gourmet food chain Balduccis. In August 2003, Bear and Trimaran Capital Partners invested $188 million to take Dallas-based Reddy Ice Holdings private. A year later Reddy Ice paid a $120 million dividend to the two sponsors; in August 2005 the company sold shares to the public. It is now valued at $455 million. Bears revenues from private equity investments, however, are fairly small. This year through mid-October, it has reaped $75 million in gains, putting it on pace to fall short of 2005s total of $154 million. Bear wins many of its underwriting mandates from portfolio companies that go public. The firm was one of three banks that led Reddy Ices debut offering, for example.
Bear pursues a similar kind of cross-selling in prime brokerage and clearing. Salespeople from that division often bring hedge fund clients in to meet with managers from other product areas a process known inside the firm as the Bear hug. Although its impossible to quantify the specific benefits, Bear officials believe the strategy has helped many of its trading businesses, particularly institutional equities. As investment firms increasingly use low-cost electronic platforms to directly access exchanges, Bear has compensated by attracting more volume from its prime brokerage clients, says Schwartz, noting that Bears equity commissions from hedge funds have doubled since 2001. In September the firm merged its clearing, equities and equity derivatives divisions into a new group called global equities to better package these services to hedge funds.
Bear also takes a different approach than most of its competitors to proprietary trading, an activity from which Wall Street firms are deriving an increasing proportion of their profits. Like many rivals, the firm is betting more of its own money on the markets. Bears value at risk, a measure of how much money a firm could lose in a given day if all of its bets turned bad, has risen from $19.4 million five years ago to $33.9 million today. But it puts that capital to work very conservatively. Bear has had only 11 money-losing trading days so far in 2006, compared with 36 at Goldman. Its ratio of trading profits to value at risk, at 52.4 percent, is second only to Lehman Brothers 56.5 percent, according to Fitch Ratings. Goldmans efficiency is 49.9 percent, and Morgan Stanleys is 34.4 percent.
Bear Stearns resembles in a way New York Giants running back Tiki Barber, wrote David Hendler, an analyst at research firm CreditSights, in a report earlier this year. Like Tiki it is consistently looking to protect the ball (its capital base) and generate attractive returns, without necessarily reaching for lead-underwriter glamour shots.
UNTIL LATELY, BEAR HAS BEEN RUNNING downhill. But now the playing field is starting to tilt upward. The housing market is cooling: U.S. mortgage origination fell from $2.7 trillion in 2004 to $2.4 trillion in 2005, according to the Mortgage Bankers Association, which predicts a decline of 15 percent this year. Thats not the best news for Bears mortgage-heavy fixed-income unit. Also, better-capitalized competitors are copying Bears vertical integration strategy. In August both Morgan Stanley and Deutsche Bank acquired mortgage-origination companies to feed their securitization businesses.
When the mortgage industry comes down, it comes down relatively hard, warns Richard Bove, an equity analyst with Punk, Ziegel & Co. If housing gets as weak as we think it will, the mortgage business wont be a contributor to their earnings. It will cause some deterioration in their results.
Fixed-income guru Spector argues that Bears mortgage business is diverse enough to thrive in a variety of macroeconomic conditions. The firms origination and securitization activities run the gamut from rate-sensitive refinancings to adjustable-rate loans and commercial mortgages. Hes confident that a tougher environment will chase away competitors.
We are not afraid of a bear market, he says. Weve gained market share in these cycles.
But there also are signs that Bears clearing and prime brokerage unit, which accounts for 13 percent of the firms top line, is slipping. Third-quarter revenues from clearing were $269 million, up 4 percent from the same period last year but down 7 percent from the previous quarter an indication, according to Bernsteins Hintz, that Bear may be falling behind amid increasingly intense competition. Goldmans third-quarter clearing revenues climbed 13 percent over the year-earlier period. As more players enter the market especially capital-rich universal banks like Citi and Deutsche big hedge funds have been able to negotiate loans as low as 30 basis points over the federal funds rate, which means the return is below the cost of capital for the lender. Bear CFO Samuel Molinaro Jr. recognizes that competition has increased. New entrants are competitive on rates and lending terms and the amount of risk they are willing to take, he notes. But, he adds, history suggests this tends to be cyclical.
Bears most glaring weakness is its laggard international business. The firm wants to increase non-U.S. revenues to between 20 and 25 percent of its total from 13 percent today. One key strategy: seeking to extract even more from its domestic hedge fund clients by brokering overseas investments for them in other words, extending its Bear hug cross-selling model outside its home market. This is easier said than done. To be fair, Bears international revenues grew at a 40 percent clip last year. But the firms competitors have a huge head start. Cayne has boosted non-U.S. head count from 750 three years ago to more than 1,000 today. That total, less than 10 percent of Bears workforce, pales in comparison to the boots other U.S. firms have placed on foreign soil. Fully 40 percent of Goldmans 20,000 employees are based overseas; Lehman has 7,000 people outside the U.S., about 32 percent of its total. Even Merrill Lynch & Co., with its armies of U.S. retail brokers, has 22 percent of its workforce stationed internationally. The 13 percent of revenues Bear derives from overseas compares with 30 to 40 percent for the wider industry. At Citigroups investment bank the figure is 67 percent.
Moreover, as the areas where Bear is relatively weak equities and M&A begin cyclical turnarounds, any hiccups at its core fixed-income and clearing units will become all the more dangerous strategically.
As the securities business becomes more capital-intensive, with firms increasingly relying on proprietary trading and lending to clients to generate profits, Bear could find itself falling dangerously behind its competitors. Cayne almost sold the firm during the last wave of mergers between brokerage houses and banks. In July 2000, after UBS spent $12.2 billion to acquire PaineWebber Group, long one of the Streets second-tier firms, Cayne said he would consider selling, but only for four times book value a multiple that would have yielded a price of $120 per share, three times Bears market value at the time.
Some analysts and investors believe Bear would be the perfect target for a bank like JPMorgan, which would gain market share in prime brokerage as well as a mortgage-securitization operation while giving Bear international reach. There would be plenty of overlap and layoffs but less than would occur in a merger between a big bank and a bigger, more diversified brokerage house. And JPMorgan CEO Jamie Dimon has plenty of experience with mergers: He took over the bank after it acquired his former company, Bank One Corp., in 2004.
It could be a marriage made in heaven, says analyst Hintz. (JPMorgan wont comment.)
Sherman of Private Capital, Bears biggest shareholder, says he can see a merger happening, but he quickly adds that Bear could just as easily continue to churn out profits as an independent entity. Its the right size for buyers, and if they were to put up a sale sign, Im sure they would get a nice price, he says. But theyve proven they can operate just fine in this environment.
Cayne is evasive about whether he would sell now. As the head of a public company, he has an obligation to shareholders to consider good-faith offers. And one longtime friend says that the CEO looks unsentimentally upon whether to sell a company. Alexandra Lebenthal, granddaughter of Sayra Lebenthal, who as head of Lebenthal & Co. hired Cayne for his first Wall Street job, sought Caynes counsel on just such a matter in May 2001. Insurer MONY Group had approached the younger Lebenthal with an offer to buy the municipal bond firm she had taken charge of in 1995. Agonizing over her familys legacy, she arranged to meet Cayne in his office at 9:00 one morning. The Bear CEO took one look at her, swiveled around in his chair and plunked a bottle of brandy on his desk, telling her, This is what you need. After Lebenthal declined the libation, Cayne reeled off a list of once-prestigious firms, including Kuhn, Loeb & Co. and Kidder, Peabody & Co., that had been absorbed by rivals. The company that wants to buy you is here, and they want to offer you money. Whats the problem? he asked. Lebenthal took his words to heart and sold to MONY a few months later for $25 million.
Cayne will need to consider the same question if the CEO of a universal bank comes knocking on the door of Bears new skyscraper. Perhaps that suitor should be carrying a bottle of brandy.